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Consolidated Carryback of Product Liability Expenses

The U.S. Supreme Court resolved a conflict between
the Fourth and Sixth Circuit appeals courts in a case involving the
10-year carryback of product liability losses under IRC section
172(b)(1) for an affiliated group filing a consolidated return. In
2000, in Intermet Corp., 209 F3d 901, the Sixth Circuit had
determined Treasury regulations sections 1.1502-11 and 1.1502-21
allowed net operating losses to be carried back for 10 years to the
extent consolidated product liability losses exceeded the consolidated
net operating loss. However, in United Dominion Industries, Inc.,
the Fourth Circuit held that the product liability losses to be
carried back for 10 years were limited to the individual company’s
respective taxable income.

United and its subsidiaries, an affiliated group filing a
consolidated return, had a net operating loss for each of the tax
years in question. Members of the group had aggregate product
liability losses that were less than the entity’s consolidated net
operating loss. The specific companies generating the product
liability losses each had positive separate taxable income. United
carried back the aggregate amount of product liability losses for the
full 10-year period. The IRS initially agreed with United but was
overruled by the congressional joint committee on internal revenue
taxation. The district court also agreed with United. However, the
Fourth Circuit disallowed the 10-year carryback, arguing that, since
the particular companies with the product liability losses also had
positive separate taxable income, none of the consolidated net
operating losses qualified for the 10-year carryback.

Result. For the taxpayer. The Supreme Court
said the Fourth Circuit was wrong in its holding that no part of the
consolidated group’s net operating loss qualified for the special
10-year carryback for product liability expenses.

United had argued that the consolidated return regulations under IRC
section 1502 supported its position. Regulations section 1502-11
requires a consolidated group to determine its consolidated net
operating loss as follows. Each group member computes its separate
taxable income as though it were a separate corporation, with some
modifications. These modifications—computed on a group basis—include
capital gains and losses, the charitable contribution deduction and
the dividends-received deduction. The group then aggregates these
separate taxable income amounts. As a result, the group’s consolidated
net operating loss is the sum of each member’s separate taxable
income, adjusted for items determined on a consolidated basis.

The majority opinion, written by Justice Souter, discusses at length
the consolidated return regulations’ single-entity approach to
computing certain items such as the net operating loss. He argues that
the case for the single-entity approach to calculating an affiliated
group’s product liability losses is straightforward. Section 172(f)(1)
[formerly (j)(1)] defines a taxpayer’s “product liability loss” as the
lesser of its “net operating loss” and its product liability
“expenses.” For a taxpayer filing a consolidated tax return,
regulations section 1.1502-21 requires the entity to compute the net
operating loss at the consolidated level. There is no definition of a
separate net operating loss in the consolidated regulations.
Consequently, entities should apply section 172, including the
subsection relating to product liability losses, at the
consolidated—not the separate-entity—level.

Justice Thomas wrote a concurring opinion. Justice Stevens wrote a
dissent in which he argued that the consolidated return regulations
should be updated to carefully describe this treatment if, in fact,
section 172 and the single-entity approach intended the above result.

The single-entity assumption often is discussed in relation to the
tax law governing consolidated tax returns. This Supreme Court case
resolved one of the many issues in this extremely complex tax law
area.

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